The specification of a hospital cost function. A comment on the recent literature.

In the empirical estimation of hospital cost functions, two radically different types of specifications have been chosen to date, ad-hoc forms and flexible functional forms based on neoclassical production theory. This paper discusses the respective strengths and weaknesses of both approaches and emphasizes the apparently unreconcilable conflict between the goals of maintaining functional flexibility and keeping the number of variables manageable if at the same time patient heterogeneity is to be adequately reflected in the case mix variables. A new specification is proposed which strikes a compromise between these goals, and the underlying assumptions are discussed critically.